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6 Stocks With Potential Pension Land Mines

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The long recession and sluggish recovery have left many Americans without much of a safety net for their finances. Unfortunately, many of the employers that workers depend on for their retirement pensions are facing problems of their own in funding their pension plans.

With Social Security facing increasing pressure and personal savings at relatively low levels, any threat to pensions for older workers and retirees could have dire consequences. Yet surprisingly, investors have largely ignored pension-plan problems despite the impact they could have on earnings and long-term prospects. Let's take a closer look at the extent of the problem and how investors should plan for it.

What's the big deal?
Pension plans hold assets that companies intend to use to provide benefits for their workers after they retire. Just as you have to set aside money regularly to save and invest for your own financial future, companies must set aside a certain amount of assets each year to cover future pension liabilities.

But pension accounting rules are flexible enough that companies aren't consistent about how they account for their required pension contributions. A report from Gradient recently cited in Barron's highlighted six stocks that stood out as being somewhat aggressive with their pension accounting practices, potentially leading to their financial statements being somewhat misleading.

Perhaps the key problem facing pension plans is the need to earn healthy returns on their investment assets. For Allegheny Technologies (NYSE: ATI  ) and Potlatch (NYSE: PCH  ) , assumptions that the plan will be able to earn 8.5% on their assets seem optimistic, given extremely low interest rates on bonds and the tepid returns from the stock market for more than a decade. Forest-products giant Weyerhaeuser (NYSE: WY  ) goes a step further, setting a 9% expected rate of return. The higher the rate used, the less a company has to save now in order to comply with funding requirements. But there's little reason to believe that one company's better positioned to earn stronger returns on pension assets than other companies.

Moreover, another sign of stress has to do with changes to return assumptions. R.R. Donnelley & Sons (Nasdaq: RRD  ) raised its estimated rate of return from 8.3% to 8.4% in 2011, even though the actual performance of its investment portfolio was poor. Many such companies appear to be counting on reversions to the mean in returns to bail them out after the Lost Decade left them short of expectations.

Other concerns
Lofty return assumptions aren't the only way a pension plan can get into trouble, though. Gradient points to Northrop Grumman as an example of a company using a discount rate that lets it produce lower estimates of future pension obligations. Any mistake in that vein could lead to similar underfunding even when the plans look fine under normal accounting guidelines.

Meanwhile, with Consolidated Edison, utility-specific practices allow the company to treat actuarial losses as assets on financials. That could cause problems for investors more used to practices in other sectors.

Much ado about nothing?
You might expect that these companies' shares would take a hit from this news. Yet investors don't seem particularly worried. In the weeks since the Gradient report came out, Weyerhaeuser, Northrop, and Con Ed have raced to 52-week highs, while Potlatch and R.R. Donnelley have bounced off lows.

Why aren't investors more worried? With such a focus on the short run, investors can hope that companies will be able to put off any costly charges to earnings until well into the future. Recent accounting rule changes support that kick-the-can mentality, and in a slow growth environment, few companies want to risk taking big charges to boost their funding levels if they don't have to.

Eventually, these companies may follow the lead of Ford (NYSE: F  ) and General Motors by offering to buy workers out with lump-sum pension payments. By taking big one-time charges, they may convince investors to downplay these costs, having less of an impact than making bigger contributions and hitting earnings every quarter. Smart investors need to watch out for such moves and understand that no matter when a company recognizes its liabilities, pension obligations are lingering out there and in many cases are becoming an increasingly large future threat.

Once you have a plan in place, you'll want to find investments that fit with your plan. We've got some great ideas for you to take a look at, and you can find them in The Motley Fool's special report on stocks that will help you retire rich. Get your free copy today while it lasts!

Also, Ford has made some bold steps in its recovery, but it still has a long way to go to get back to its past glory. Take a look at its prospects in our premium investment report on Ford.

Fool contributor Dan Caplinger steps carefully in minefields. He doesn't own shares of the companies mentioned in this article. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of Ford, Northrop Grumman, and Weyerhaeuser. Motley Fool newsletter services have recommended buying shares of Ford and General Motors, as well as creating a synthetic long position in Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy won't blow up on you.

Read/Post Comments (4) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 14, 2012, at 10:12 AM, kurtdabear wrote:

    At the time RRD raised their anticipated rate of return (ROR) on their pension plan, RRD common was paying a dividend higher than their estimated ROR. While I realize there are limitations on a company investing its pension plan in its own stock, maybe they're planning on finding some other stocks paying returns similar to their own (Long RRD). Had they been allowed to put the whole plan into their own stock, they'd be sitting on an 18% annualized rate of return right now.

  • Report this Comment On August 14, 2012, at 2:55 PM, BKlounge22 wrote:

    The funding rules and accounting rules for pensions are very different. Assuming a higher rate of return on assets for accounting purposes does not in any way impact the company's required cash funding of the pension plan.

    They may be inflating earnings, but the cash flows they have to commit to the pension plan don't change.

  • Report this Comment On August 14, 2012, at 5:29 PM, Bully4You wrote:

    As a retired employee of Teledyne, Inc. which merged with Allegheny Technologies many years ago, I find it disturbing that the author would question ATI's pension condition. For years, Teledyne itself had accrued pension assets significantly in excess of its pension liabilities due to the hands-on investment skills of its founder and CEO, Dr. Henry Singleton. It was for this reason that Teledyne became an acquisition target and eventually merged with ATI.

    Each year, I receive a pension statement from ATI. According to the latest statement in April, 2012, the ATI pension continues to have assets in excess of liabilities, although that amount has decreased from prior years. There are not many US large company pension funds that are in such excellent financial condition.

  • Report this Comment On August 15, 2012, at 6:30 PM, SalemWish wrote:

    Some of the comments here strike me as naive as far as how pension assets and liabilities are calculated.

    If memory serves me right, the funding requirements of a defined benefit pension plan depend on the liabilities (which change every year) and the assumed earnings rate of the assets (which can be changed pretty easily).

    The pension liabilities are estimated by taking into account the gender and age of retirees and potential retirees, and matching that to mortality tables to find out how many years the pension is likely to be paid and multiplying that by the pension owed/earned (usually a multiple of average salary and years worked times the benefit percent). If the computation is done properly, you can come up with a reasonably accurate liability estimate, and I can't think of obvious ways it could be fudged or understated, except (maybe if allowed) by using a different mortality table.

    However, the assets necessary to cover this liability can be manipulated by changing the assumed earnings rate. Thus, if a company doesn't have enough money to make a contribution to the pension, or just doesn't want to, they increase the assumed interest rate, and the existing assets magically appear to be more than enough to meet the liabilities.

    So using the inflated earnings rate, the lump sum amount for each individual would be understated if they are offering a buy out or terminating the plan. It sounds like cheating to me....

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